After gaining almost 16% in just over two months, what should one think about Eurozone equities? Are they expensive? Too expensive? Should one remain exposed? Some multiples are high and some risks justify maintaining a certain degree of caution in the short term, but we remain positive about Eurozone equities.
What are the reasons for this recent rally?
- The announcement of the €60 billion monthly purchase programme by the European Central Bank and its consequences for currencies, with the euro depreciating by almost 15% against a basket of currencies.
- This last development is coupled with a drop in oil prices, creating a sharp improvement in the economic outlook in the Eurozone, which is visible in the evolution of PMI indices (+2,2 points over three months to 53,3 for the Eurozone composite index in February). The breakdown of fourth-quarter GDP and the improvement in retail sales are evidence that consumption has picked up again. The fall in unemployment should boost it.
- Other factors: the relative attractiveness of the Eurozone equity market in comparison with other asset classes and, in particular, its underperformance of the US equity market in 2014. The euro’s depreciation has also made the area more attractive to investors from the rest of the world.
Valuations have become more demanding in a context where risks have not disappeared…
Despite the improvement in the economic environment and the euro’s depreciation, index earnings forecasts have only been edged up to date. This is partly the result of the fall in the oil price, but not exclusively.
The market’s strong rally year-to-date has put strains on valuations, with the Euro Stoxx index trading today at almost 16 times 12-month forward earnings, a level not seen since 2002.
Risk factors are still essentially political or geopolitical:
- Negotiations between the Greek government and European institutions remain deeply strained and the probability of Greece exiting the Eurozone, whether wanted by one of the parties or accidentally, is not negligible. That said, the current situation has nothing in common with that in 2010-2011: the ECB is buying massive amounts of sovereign debt, the Eurozone has introduced the European Stability Mechanism and, last but not least, the European banking system’s exposure to Greece is no longer systemic.
- It is not impossible that tensions between Russia and Ukraine will increase again despite the agreement reached, leading to a more severe conflict.
… but these negative factors should also be put into perspective
The first positive factor: the ECB’s debt purchases surpass net issues by Eurozone governments. The crisis of confidence that hit some Eurozone countries in 2010-2011 has thus little chance of being repeated. Quantitative easing measures by other central banks have always boosted the equity markets.
The second important factor to take into account is relative valuations. Eurozone equities are not as cheap as they used to be, but they remain far cheaper than other asset classes. It is worth recalling that the dividend yield of European companies is four times higher than the yield to maturity of good quality private bonds (investment grade). The chart below illustrates the inverse PE (proxy of the total return on equities) compared with yields on fixed-income asset classes.
Lastly, the companies’ earnings to which high valuation multiples apply will very likely be revised upwards. The euro’s depreciation and the improvement in the domestic environment will contribute to this trend. The current level of company margins in the Eurozone is relatively low and will improve as activity picks up. At present, the consensus is forecasting earnings growth of around 13% in 2015 and 14% in 2016. An upward revision of these levels is probable.
In the short term, high valuations appear to be underpinned by positive factors, such as the ECB’s actions. In the longer term, we think that the equity market rally should continue.
In 2012, we modified our investment process to include a short-term dimension in our asset allocations. In brief, we use 70% of our room for manoeuvre to gain exposure based on economic and market fundamentals and 30% based on the market’s shorter-term outlook (sentiment, momentum, geopolitical events, etc.). We have long since been highly favourable to Eurozone equities. Bear in mind that their cumulative performance* since December 31st, 2008 is almost 100%, whereas an investment in German sovereign bonds with a 7-10 year maturity returned around 50%.
We continue to favour the Eurozone equity market. However, the market rally has led us to take some of our profits by reducing our long-term component, which was at its maximum level, by 20%. We had already reduced our short-term component to neutrality. These choices allow us to maintain high exposure to the Eurozone equity market while taking a portion of our profits.
This has given us more leeway to take advantage of any weakness to buy equities.
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